Not Your Father's Value-Growth Rotation

DEPENDING ON WHO YOU TALK TO, VALUE investing is either dead, reawakening or in need of a new definition.

Value funds outperformed growth funds in the second quarter, but value stocks as a whole trailed their growth counterparts badly in the first half, according to data from Russell Investment Management. The Russell 1000 Growth Index, for example, jumped by 11.53% in the first half, while its value counterpart slid 2.87%. Over three years, value is down by 11.11%, while growth is off 5.45%.

"On the surface, at least, it's a pretty discouraging picture" for value investors hoping for a revival in their approach to stock-picking, admits Bob Doll, global chief investment officer for equities at BlackRock Financial Management.

Rarely had so many seemingly cheap stocks, like Bear Stearns, Citigroup (C), Freddie Mac (FRE), General Motors , Macy's (M) and JCPenney (JCP) turned out to hold so much more downside.

These and other disasters have affected not only average mutual-fund managers, but also legendary value investors like Third Avenue Value Fund's Marty Whitman, Berkshire Hathaway's Warren Buffett (his Goldman Sachs investment notwithstanding), and Legg Mason Value's Bill Miller.

The conventional wisdom -- especially in light of second-quarter returns -- is that value will reassert itself, if it hasn't already started to. But there could be more going on than a standard rotation. For one thing, the diversity of returns from value funds suggests that some are changing their definition of value. For example, small-cap value-oriented Ariel Fund (ARGFX), run by John Rogers, was up 13.05% in the first half, placing him near the top of all funds, regardless of style. In contrast, Vanguard Windsor II Fund (VWNFX), a large-cap value vehicle, gained just 2.56% in the first half.

"There is so much divergence in performance among the different value funds, it's impossible to reach any conclusions about a broader trend," says Michael Breen, senior analyst at Morningstar.

A lot of the divergence resulted from a fund's holdings in financials: the fewer the better, says Dmitry Khaykin, managing director of ClearBridge Advisors and co-manager of its large-cap value-investment products. Some funds, he notes, were focused on metrics like price-to-book ratios; seeing Bear Stearns, for example, trading at only 50% of its historic book value, they bought more.

But then Khaykin, one of a growing number of advocates of a less-rigid definition of value, says he and fellow ClearBridge managers sold Bear shares before they went into free-fall, realizing that the magnitude of the leverage on its balance sheet made it almost impossible to understand what the brokerage firm's real "value" might be. He also was an early seller of Freddie Mac.

Transparency aside, more and more investors are taking an agnostic approach in this style-debate. "There's a large and growing group of people who don't see a big benefit from trying to figure out whether growth or value will outperform in the future," says Brian Shanahan, head of the U.S. active quantitative stock-investing team at State Street Global Advisors in Boston. "Their focus isn't on the traditional kinds of metrics and whether a stock is growth or value, but whether it's a good business model, and what the risk might be."

One reason that approach is gaining adherents is that many traditional value metrics are less useful in today's environment.

For instance, value investors have often viewed high dividend yields as an indicator of value -- but nowadays, companies of all kinds are slashing payouts to preserve cash. Similarly, book value hasn't been a very trustworthy indicator of value in financial stocks.

Going forward, good value managers will have to have what Dave Cameron, president and chief executive officer of Boston Co. Asset Management, describes as "a more fluid" approach to valuing stocks, and dig in their heels to avoid being pigeonholed based on any particular set of metrics. "Style-diversification just didn't work at all last year," Cameron says, bluntly. "As a result, investors will be looking for managers who are more creative in their approach to investing than simply calling themselves 'value' or 'growth.' "

"Is pigeonholing managers as 'value managers' dead? I would say 'Yes'," Cameron argues. "Is the investment process of trying to generate returns by understanding the value of individual securities dead? Absolutely not." But that implies that the investor is given the latitude to go wherever he or she believes value exists, regardless of whether it is in a traditional 'value' sector or has to be located using more eclectic sets of metrics.

Do the second-quarter gains augur better times for value investors? Not really. "We think value traps are going to be more prevalent than they have been for a long time," says Steve Barry, the New York-based chief investment officer of Goldman Sachs Asset Management. In today's stepped-up Darwinian environment, Barry argues, "the walking wounded won't survive as readily."

BlackRock's Doll insists, "Value investing isn't dead; it just hasn't emerged from hibernation yet this year."